#Bitcoin fails as a money b/c of its naive monetary policy.

Many people think government printing too much is evil, so a fixed money supply must be good. The reality: a money that cannot expand would crush the economy and put us all in poverty.

Here’s why and how to fix it.

To see this we need to understand why monetary deflation and expanding economy do not go together.

Let’s simplify so it’s easier to see. Say, we have an economy with 1 product— twinkie, and 1 currency— dollar. Price of 1 twinkie = $1.

Alice, a twinkie entrepreneur, hires Bob to help make twinkies. Alice’s company makes 1 twinkie a year, so company revenue is $1. Bob’s salary is $0.5 and Alice takes the other $0.5.

What happens when productivity goes up (a.k.a. economy grows)?

When prices/wages are stable, Alice is always motivated to find better ways (read: new technology) to make twinkies (read: increase productivity).

If the company manages to make 2 twinkies instead of 1 with the same resources, Alice’ll make $1.5 instead of $0.5 ($1 x 2 twinkies – $0.5 wage cost = $1.5).

But if price quickly drops as productivity of twinkie doubles— i.e. twinkie price deflates to $0.5— Alice would still make $0.5 after going through all the trouble to increase productivity (Revenue doesn’t increase: 2 twinkies x $0.5 = $1, while wage cost is still $0.5).

(Note: In our toy economy there’s only one product, so purchasing power of $0.5 is higher than before. In reality, $ is not used to just buy twinkies but a wide variety of other goods & services. So it’s the amount of $$ earned that Alice cares about.)

Why would Alice even bother to improve productivity, when she ends up still making $0.5 as she did before?

You say, since price dropped (deflation), shouldn’t wage drop too? Why doesn’t Alice pay a lower salary to Bob, or do profit share so that wage adjusts with revenue?

But Bob would tell you, “Wait what? No f*cking way!”

A twinkie company is a risky business. Bob didn’t sign up to share that risk and he doesn’t want to.

Alice can experiment with new technologies however she wants. It’s her company. Bob is just a hired gun who wants to get paid.

Bob: “She said she’d pay $0.5. $0.5 is my right! Why are these corporations so evil?!”

Employer-worker contract is an agreement about risk as much as about money exchange. Workers signed up to exchange labor for a more or less promised pay.

That’s why in reality wages are extremely difficult to adjust downward. Seasoned entrepreneurs would tell you to think carefully about raises— they’re easy to give, hard to take back.

What happens when companies need to make investments?

Let’s make our toy economy a bit more complex. Alice wants to find a better way to make twinkies. To do so, she has to invest in R&D (research & development), and that’s costly and risky.

Alice goes to Mary to borrow $0.5 with a 20% interest rate. She invests the money in R&D and keeps her fingers crossed.

Thank goodness! She discovers a new way to double twinkie-making productivity. (Mind you, it can easily go the opposite way. She could have invested all with nothing to show for. That’s what risk is.)

If price is stable, Alice now makes $0.9 ($1 x 2 twinkies – $0.5 wage cost – $0.6 loan repayment = $0.9). That’s great. She was only making $0.5 before.

But what happens if price quickly drops from $1 to $0.5 as productivity doubles? Alice makes $0.5 x 2 twinkies – $0.5 wage cost – $0.6 loan payment = -$0.1.

She’s now royally screwed, even though the investment was supposedly a “success”.

You say, if price drops, that means purchasing power of $ is up. So interest rate, denominated in dollar, should go down by same degree.

But Mary would tell you, no way! Her argument is the same as Bob’s. Mary and Bob didn’t sign up to be the main risk taker of a venture. They only agreed to provide capital and labor in exchange for a (relatively) predictable return.

It’s Alice, the entrepreneur, who signed up to take risks, with the prospect of hopefully capturing the gain of productivity growth. But if price quickly reflects productivity growth, it makes that impossible.

You say, but things have gotten cheaper with technology progress. Look at how much the prices of TV, computer, and smart phone have dropped?

Yes, but that drop happens gradually. It allows the companies that invested in tech progress first to capture the gains before the product becomes a commodity.

Plus, new products & services are invented every day to reset the price curve, and productivity growth is slower in some categories than in others. Money supply growth is keeping apace with overall productivity growth. So the price level of aggregate economy stays stable.

Because technology progress happens all the time & economy has become more and more abundant, people take it for granted. Don’t!

Realize that for every little progress that happened, someone took the risk and invested to make it happen.

They did so because a capitalistic economy with price stability provides powerful incentives to invest and to innovate. When you have deflation, you drastically weaken those incentives and economy stagnates.

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What happens if you have a money whose supply cannot expand, or God forbid…shrinks?

The long-run determinant of inflation / deflation:

Inflation rate = Money supply growth – Real GDP growth – Money velocity growth

Money velocity fluctuates up/down and doesn’t have a trend growth (i.e. ≈ 0). That means if real GDP grows (aka productivities increase, goods & services more abundant), money supply needs to grow too, otherwise you have inflation rate < 0, i.e. deflation.

In our twinkie economy, we initially make 1 twinkie and money supply is $1. So the price of twinkie = $1. When twinkie productivity doubles, money supply needs to double as well to keep the price of twinkie at $1.

If you fix money supply, the price of twinkie drops to $0.5. You screw Alice.

If productivity stays same, but you cut money supply by half, the price of twinkie also drops to $0.5, except in this case not because of any action from Alice.

Alice is like, “What have I done to deserve this?”

Also note that deflation begets more deflation:

#bitcoin has a fixed supply. If it’s used as currency, as economy expands, prices of goods & services denominated in BTC drop. That encourages BTC hoarding as people expect it to be worth more tomorrow—> more BTC taken out of circulation —> money supply shrinks further.

Yes with deflation each satoshi can buy you more stuff. But with investment/production incentives destroyed, you soon won’t have more stuff to buy.

You say, we can still have a currency with fixed supply like bitcoin, we just need to entirely change how interest rates / wages / prices are set.

Yes, theoretically possible. But what for? Why would you ask the whole economy to bend backwards to fit the arbitrary tyranny of a currency, when money is supposed to serve the economy, not the other way around? Just so that BTC hodlers could see their asset appreciate?

Give me a motherf*cking break!

Stable prices— not persistent inflation or deflation— is a fundamental feature of any good money.

Bitcoin has a place as a store-of-value asset in a new monetary paradigm. But it’s unfit to be a currency and never will be.

Any other layer 1 chain that aspires to become a dominant medium of exchange / unit of account should take heed of this.

Money policy should be programmed in a way so that money supply will expand along with the volume of economic activities happening on the platform.

There should also be mechanism to accommodate cyclical change— lower money supply when economy is running too hot and increase when it’s in recession, to help economy cope with volatility.

These rules can be programmed so no subjective discretion / potential abuse like with a traditional central bank.

#Bitcoin is not a new economic paradigm. Programmable monetary policy is.

1 Comment

  1. Is the ever higher cost of energy for Bitcoin mining, as a major leak of value, being too easily ignored?
    Given that other more efficient L1 systems exist (which are also at least as secure and scalable), should we not expect value to flow towards the most efficient protector of value?


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